Facing Extinction, Hedge Funds Go All In: Take Net Assets To All Time High, Cash To Record Low

Several years ago we said that in the New centrally-planned normal, in which the Fed chairmanwoman is the Chief Risk Officer of the s0-called market, and where no selloffs are allowed because any major drop in a market artificially supported by trillions in artificial liquidity, would probably be its last (as it would crush the "credibility" of all-in central banks) that old "smartest money" concept, the 2 and 20 hedge fund, has become an anachronistic relic of the past (especially once Stevie Cohen ruined the game for everyone and took legal insider trading aka "expert network" out of the picture and forced hedge funds to make money the old fashioned way - legally).

Now, for the first time, we have empirical proof that hedge funds are indeed on the verge of extinction courtesy of the New artificial Normal. In its hedge fund quarterly note (which it clearly ripped off from Goldman), Bank of America has concluded what we said in the beginning of the decade: "Hedge Funds are less attractive post the financial crisis with lower alpha and less diversification benefits." Or, in other words, hedge funds (for the most part: this excludes those extortionists also known as activists who successfully bully management teams into levering up in order to buyback record amounts of stock, in the process burying their companies and employers when the next downturn arrives) no longer provide a service commensurate to their astronomical fees. Or any service, for that matter, that one couldn't get by simply buying the S&P500.

Here is the tombstone for hedge funds, from Bank of America, in two paragraphs:

Since the financial crisis, Hedge funds have generated positive alpha of 0.0999%, which is lower than the 0.7922% of positive alpha generated before the financial crisis. Additionally, hedge funds are more exposed to market risks than before the financial crisis. Since 2009 the CAPM model has explained 75% of HF returns, but pre-financial crisis CAPM explained only 2.96% of returns. In summary, although hedge funds still offer positive risk adjusted returns, the investment is becoming less attractive as an asset class due to the lower alpha and less diversification benefits.

Equity L/S strategy has a negative alpha of -0.0993% since the financial crisis, compared to a positive alpha of 0.9353% before financial crisis. Moreover, Market risk premium and market exposure explains 81% of HF performance, compared to 42% before the financial crisis (bottom charts)

The two paragraphs above are indeed the death knell of the hedge fund world, and for those who don't get it, here it is in plain English - hedge funds no longer generate alpha, they merely trade on (levered) beta. As a result, investors in hedge funds have virtually none of the market upside, all of the downside, and are far more exposed to drawdowns and volatility (assuming there is any). In short - in a market in which crashes are no longer allowed, hedge funds provide zero value and furthermore, since many of them are short the same hedge fund hotel stocks which blow up in everyone's face once there is a short covering panic, most hedge funds end up underperforming the market year after year, for each consecutive year since the financial crisis.

Of course, nobody excepts hedge funds to just curl up in a ball and die. And they won't, at least not without a fight - PMs are just too used to making hundreds of millions in performance fees each year to retire to that ranch in Montana just yet.

So what are hedge funds to do? Why go all in of course.

As Bank of America also reports, "based on the quarterly 13F filings and estimated short positions of the equity holdings of 912 funds, we estimate that hedge funds increased net exposure to $646bn notional at the beginning of 2Q 2014, up from a record high of $617bn atthe end of 2013. Percentage-wise, net exposure remains at 71%, the same as at the beginning of 2014. Net exposure fell further to 61% after subtracting ETF shorts, down from 63% at the beginning of 2014. Cash holdings remain at a record low 3.6%.

Finally, Bank of America admits that its analysis does "not include derivatives, which are potentially a larger source of exposure and leverage." This is something we covered back in April when we explained who are "The Most Levered Hedge Funds" showing how off the books leverage can make a $15 billion AUM hedge fund like Citadel manage $142 billion in "regulatory" assets.

And now, since chasing (or as it is jovially known "seeking") alpha is no longer possible, let's all lever up on beta and pray to the Hon Yellen that nothing bad ever happens again.